Lessons from the Housing Bubble

Learning from history requires a thoughtful analysis of what actually happened, not endlessly parroting a politically convenient slogan. The current economic crisis is not a repudiation of free markets, nor is it a repudiation of deregulation. Such an “explanation” is simply Barack Obama and the Democrats peddling their same discredited elixir under a new label.

The causes of the current economic crisis are complex, and many people are at fault. Focusing on the housing bubble, the housing crisis will define the Bush II economy just as the technology boom and bust of the 1990’s defined the Clinton economy. While bubbles developed during both periods, from a fundamental economic perspective, the two experiences have important differences. The lessons we need to learn from the current housing bust come from understanding these differences.

Rising wealth across the globe has increased the supply of money available for investing. During the 1990’s, the investment funds were put to good use – funding the Internet and information technology revolution. The investment in information technology transformed our economy. While the real annual long-run GDP growth in the U.S. is believed to be around 2.5% - 3.0%, from 1996 through the first half of 2000, real average annual GDP growth accelerated to 4.5%.

The technology boom led to an unrivaled and sustained acceleration in productivity for the average worker. As the productivity gains increased the effectiveness of workers, income levels for all Americans rose. When coupled with the capital gains tax reductions of the 1990’s, the result was the late-1990’s economic boom.

Like many transformational technology revolutions – such as the railroads of the 1800’s or the automobile industry of the early 1900’s – the information technology boom was associated with financial excesses. The life altering potential of information technology created a euphoria that was unsustainable. The result was the boom and bust of the stock market and with it the rise and fall of many early Internet companies and icons.

Importantly, the 1990’s boom was rooted in the creativity of individual entrepreneurs. Worldwide capital flows supported the dreams and visions of these entrepreneurs, all to the benefit of businesses and consumers worldwide. This was not the case for the 2000’s housing boom.

During the late 1990’s, Congress, guided by “socially responsible” visions, wanted to extend the American Dream to more people. To achieve this goal, the government unleashed Fannie Mae and Freddie Mac – as well as Community Reinvestment Act and Department of Housing and Urban Development regulations – to divert more money toward housing. In so doing, a housing bubble was all but inevitable.

Certainly, flaws in the private sector significantly heightened the risk (and ultimate cost) of the housing bubble. Poorly structured securitization left banks with “no skin in the game” when they extended mortgages. This, along with poorly executed ratings from the ratings agencies is problematic and needs to be addressed. But, it was the government that created the incentives to over-invest in the housing sector in the first place. Without the government incentives, the housing bubble would not have developed.

Since 1970, residential construction activity has been typically around 4.5% of overall economic activity. Due to the government fostered housing boom, residential construction’s share of the economy swelled to an unprecedented 6.3%. Greater investment in housing replaced investing in other assets – including the accelerated technological investments that drove the 1990’s boom. The implication of this change was dramatic.

As the housing boom wore on, successively greater shares of the housing stock were being purchased by borrowers that were not capable of financing the home. From an economic efficiency perspective, the “productivity” of the money invested in these new houses was falling. Instead of investing in new technologies that could enhance our efficiency, government incentives drove more and more money toward building houses that could not be sustained.

Furthermore, many of the construction jobs created by the boom in the housing sector were filled by illegal immigrants, as the work and pay, while not attractive to many Americans, was attractive to this group. The surge in illegal immigration during the housing boom, and its subsequent drop during the housing bust, is simply a rational response to the capital investments that the American economy was making.

What is troubling for American workers, however, is not the illegal immigration but the skewed capital investment. Government policies encouraged investment dollars to be allocated toward less productive projects that will not increase worker productivity. Without productivity growth, there is no income growth.

The way forward takes time. Due to the excessive build-up of unproductive homes, we must go through the process of readjusting our capital stock toward more productive uses. Because real resources were used to build these homes, money that could have been allocated toward projects that would have increased workers incomes and our national wealth, have been wasted. Luckily, we have already experienced much of the re-adjustment pain, although there is more to come. Oil prices have been dropping as well, which should offset some of the pain as the affordability of food and gas should improve.

We will be unlucky, however, if we take the wrong lessons from our recent history. The housing crisis did not occur due to deregulation or a failure of the market. What has failed is a regulatory structure that promoted “socially responsible” visions above common sense. Time and time again, history has shown us that chasing the economic dream of a central planner ends with a crisis. The housing bubble is simply another example.